I have been postponing a proper discussion of Fed “sterilization” because it’s a tricky thing, but events are moving quickly. So with the caveat that I am writing this in the wee hours of the morning, here it is in a nutshell: Our banking system is a “fractional reserve” one. That is, if you take $1000 in actual cash to a bank and deposit it into a new checking account, the bank doesn’t put the pieces of paper in a drawer with your name on it. On the contrary, the legal reserve ratio is (currently) 10 percent, meaning that banks only have to have 10% “backing up” the total outstanding deposit liabilities held by their customers. By putting your $1000 of actual currency in their vault, the bank can not only give you a checkbook and let you walk around, thinking you have $1000 “in the bank,” but it can also give new lines of credit to other customers, such that now the community thinks they have $10,000 more money in available deposits. (This is because the $10,000 in new checkbook balances is backed up by the new $1000 in cash sitting in the vault.)

Now, in order to satisfy its reserve requirements, banks don’t actually need to have green pieces of paper sitting in their vaults. They can also count their “reserves” on deposit with the Federal Reserve itself. So just as you can have a checking account with your local bank, so too do the big member banks have accounts with their bank, i.e. the Federal Reserve.

OK hang in there folks, we’re getting to the good (actually, awful) stuff. Because of the fractional reserve system, when the Fed injects new reserves into the credit markets, there is a multiplier effect. By itself, then, the massive loans being granted to troubled financial institutions should have caused huge spikes in the money supply, broadly defined.

However, Bernanke has actually been a tightwad thus far. This is an important point that many casual observers have missed. Ever since the Fed started pumping in massive, short-term injections of “liquidity” in September 2007, Bernanke has been very careful to “sterilize” the injections. Specifically, he sold some of the Fed’s holdings in bonds, to the private sector banks. I.e. the Fed itself owned hundreds of billions of dollars worth of Treasury debt, just like any other big institution can have lots of bonds issued by the US Treasury on its balance sheet.

Now when the Fed sells, say, $100 million of bonds to Bank XYZ, it debits XYZ’s reserve balance. It’s as if your local bank “sold” you a new batch of checks because you were running low, and then debited your checking account by $50 to pay for them. But unlike the private sector case, where your bank now has an extra $50 in its “checking account” as it were, when a bank reduces its reserves with the Fed, that just disappears from the system. (In reverse direction, this is how the Fed creates money out of thin air. It literally just adds numbers to a client bank’s account balance. Poof! Why bother digging up gold when you can change some 0s and 1s in a circuit?)

So, to sum up, thus far Bernanke has been offsetting his injections of new liquidity to a given bank, by selling Fed assets to other banks. On net, the rescue actions have not been pumping in new liquidity, and have not been expanding the monetary base. (More accurately, Bernanke has used the sterilizations to expand the base much more slowly than would have occurred without the sterilization. I.e. the base has still grown, but not nearly as much as some libertarians think, reading the headlines every day.)

We’re now getting to the climax. The problem is that with the new promises made in the last few days, the Fed may soon run out of assets to burn. In other words, the Fed can print money out of thin air, but it had a finite stock of Treasury assets that it was burning through in order to sterilize its injections. I’ll let Robert Wenzel take it from here:

Up until now, the Federal Reserve has been sterilizing its bailout activities by either loaning out or selling Treasury securities that it has had in its portfolio, to match the bailouts activities it has been conducting. In the last 52 weeks, the Feds portfolio of Treasury securities has declined by $303 billion and stands at $476 billion. But, commercial banks and bond dealers, just in the last seven days, borrowed $348.2 billion from the Federal Reserve as of yesterday.

If the Fed attempts to sterilize these borrowings it will be down to $128 billion in its portfolio. If it does sterilize the borrowings, in a day or two with only $128 billion in Treasury securities left, and more borrowing likely, the Fed would be forced to print money, as they would have run out of Treasury securities for further sterilization operations. Either way, it is likely the Fed will start printing money at unheard of rates.

Indeed, they may have already started. According to the latest data, during the week ended September 22, the Fed increased the money supply by nearly $100 billion.

We may be about to experience the greatest inflation the United States has experienced since the Civil War. Gold could break above $1,000 an ounce in record time. You have been warned.